ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

It is expected that the US Securities and Exchange Commission (SEC) will soon finalize rules that will mandate the clearing of certain trades involving US Treasury securities. Given the pivotal role US Treasuries play in the derivatives and financial markets, it’s critical we think hard about the various implications and consequences of the SEC and other rules in combination to ensure we don’t negatively impact liquidity and market capacity.

Proponents say broader clearing of US Treasury transactions will help reduce settlement risk, enhance liquidity and increase transparency and balance sheet capacity. But it also comes with costs due to clearing fees, margin requirements, documentation and potential systems development.

There are a number of operational challenges that need to be addressed too. For one thing, there needs to be careful consideration of the most appropriate clearing models – both those that are available to clients today and potentially others. Robust legal documentation and appropriate processes and structures for the segregation of client margin will also need to be put in place and tested – a massive undertaking that will take time given the number and diversity of participants active in this $25 trillion market.

We’ll engage closely with members when the rule is finalized and assist with implementation where we can. In particular, we think we can bring our previous experience in cleared and non-cleared derivatives to bear – both in terms of providing input on client clearing models and drafting appropriate documentation.

But operational changes aren’t the only driver of costs – certain prudential requirements could also weigh on market participants, including those that may need to intermediate additional client clearing. These include the supplemental leverage ratio, which acts as a binding constraint on some banks and has contributed to departures from various services and business lines. Meanwhile, the credit valuation adjustment framework under the US Basel III ‘endgame’ proposals includes exposures to clients on cleared transactions – something we think is unnecessary and impacts the cost of client clearing businesses.

More broadly, the introduction of minimum haircuts for securities financing transactions under the US Basel III proposals would make it more expensive for certain market participants to raise the funding vital for meeting margin requirements.

ISDA will run an industry quantitative impact study to obtain a detailed understanding of how the proposed US capital rules will affect banks, but we strongly believe that US regulators should work together to ensure incentives are aligned.

Other proposed rules could also affect capacity, including the SEC’s changes to the definition of dealer and government securities dealer. This would require principal trading firms and other entities that either assume certain dealer-like roles and/or engage in certain levels of buying and selling of government securities to register as a dealer with the SEC and become a member of a self-regulatory organization. The quantitative trigger would apply irrespective of whether these transactions have anything to do with providing liquidity or other dealing activities. While this proposal would extend the SEC’s oversight, it could end up being counterproductive to the objective of maintaining a deep and liquid US Treasury market.

ISDA’s mission is to foster safe and efficient derivatives markets. To achieve that, we need a Treasury market that functions effectively and is liquid and resilient, even during stress. But at a time when Treasury issuance is at record highs and could rise to $46 trillion by the end of 2033, we must think carefully about whether and how the various measures – the Treasury clearing proposal, the Basel III requirements and the dealer registration rules – might interact to reduce capacity, increase costs and reduce liquidity of this vital market.

ISDA’s Derivatives Trading Forum in London on November 7 will consider the global impact of the proposed US Treasury amendments. It’s not too late to register – click here for more information.

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